Negotiations over details of loss buffer tables is becoming a key feature of all reinsurance and retrocession renewals for providers of collateralised sources of capacity, such as ILS funds and investors.
Following the impacts of recent heavy catastrophe loss years, the trapping of collateral and now further issues caused by loss pronouncements that some see as overly conservative with recent events, the mechanisms and structures used within insurance-linked securities (ILS) contracts are coming under increasing scrutiny.
As we explained in a recent article, issues related to buffer tables, collateral lock-up and the resultant impact on capital efficiency are the biggest issues for the ILS market as 2020 fast approaches.
The effect on capital efficiency and ultimately the cost of that capital can be significant, particularly if collateral is too easily trapped, too much of it is trapped, or it becomes hard to achieve any release.
Nobody in the ILS market would argue with the need for a ceding company to be able to retain and hold onto collateral that could be required for loss payments in the future, under the right circumstances and when the right data is provided and made available to back up this need.
But over the last few years the shortcomings of some buffer loss tables have become evident, as collateral has perhaps been too easily trapped and held, or too egregiously in a number of cases.
Most people now agree that it is time for a rethink and perhaps redesign of the buffer loss table mechanism, or at the very least a more analytical look at how to make it truly responsive to the ceding companies loss payment needs, while protecting the interests of the investors.
This is resulting in some prolonged negotiations over loss buffers at renewals for this January 2020 season, we understand, with a number of collateralised reinsurance and retrocession players looking to negotiate them lower and find a level where both sides interests are protected in the contract.
Recent typhoon Hagibis has raised some further concerns about loss buffers and how they are being utilised.
A number of ceding companies have used particularly high loss picks for Hagibis, fearing a potential repeat of Jebi loss creep. But there has been some disagreement over whether these high loss picks are realistic among those whose collateral is being, or is at risk of being, trapped.
Market sources suggest ceding companies have numerous reasons for setting higher loss picks for Hagibis as well, such as attempting to drive retro market pricing conditions, or setting aside more reserves in case of other lines going pear shaped (the increasing chatter around the health of the market’s casualty book).
We’re not sure on the actual impact of overly high loss picks on collateral trapping, but from the amount of discussions it stimulates it’s clearly seen as a risk by collateralised capacity providers.
While the loss buffer table is in some cases a rudimentary tool, it also serves the very valuable purpose of securing obligations, but in some cases the trapping of a large percentage of capital over and above where losses sit at that time is seen as unnecessarily onerous by many.
As a result of which the negotiation over the lowering of loss buffers is now happening apace and expected to be a feature of renewals through 2020.
We understand that negotiations over buffer loss tables has also been particularly acute in attempted renewals of quota share sidecars and private ILS transactions in quota share form.
Here, we understand that investors have in some cases been holding their ground and attempting to push through changes to buffer tables, that had in some cases had their terms firmed up in the initial marketing documents associated with sidecars and private deals.
This happened a year ago as well, with some sidecars of well known reinsurers facing a significant negotiation around loss buffers before they could get over the line.
Interestingly though, in 2019 and for the 2020 renewal seasons, risk models are expected to play into these negotiations as well.
Analysts at Goldman Sachs pointed out recently that while collateralised reinsurers and ILS funds are negotiating loss buffers lower where they can, the effect is sometimes cancelled out by catastrophe risk models that have been adjusted upwards.
The analysts also mention the habit of ceding companies to book losses particularly conservatively at this time, which they also see as having a countering effect on any successfully negotiated lowering of loss buffers.
The need to make capital and collateral work as hard, effectively and efficiently as possible benefits all sides of the transaction, in the ILS and reinsurance world.
Therefore these negotiations are likely to be an ongoing feature of renewals for the coming year, or more. But there will be an increasing need for ceding company transparency, more timely and accurate data on claims and loss estimations, which is likely to be the ultimate driver of finding a middle-ground where all sides are happy with the collateral related terms in the majority of cases.